What Is Bitcoin?

Investors and journalists have likened the craze for investment in cryptocurrencies like Bitcoin to the American Gold Rush of the mid-1800s. Others compare the mania for the digital currency to the Dutch craze for tulips in the 1700s. It remains to be seen whether Bitcoin and its digital cousins will endure and become a new gold standard or lead the market into collapse like the Dutch tulip mania.

Digital Currency

Digital currencies, or cryptocurrencies, are electronic tokens generated by networks of computers to replace traditional currencies. Paying for something with digital currency is not the same as paying with a credit card, debit card, PayPal or ApplePay, which all electronically access conventional currencies such as U.S. dollars, British pounds and Chinese renminbi.

The electronic tokens in digital currency have value based on the exchange of conventional currencies and commodities for the tokens through special internet exchanges, such as BitPay. These exchanges function somewhat like PayPal but are not associated with that company. Like gold, conventional currencies and commodities are valued based on national and international banking standards.

Creating Digital Currency

To make cryptocurrency, a distributed network of computers in a closed, internet-based community works through a set of complex cryptographic algorithms, and the output of the specialized programs is cryptocurrency represented by digital tokens. The tokens are only valid for trade within digital communities, and individuals and organizations can open accounts — also called wallets — in the specialized communities.

The founders of the communities limit the number of tokens the computers underpinning the transactions in the community can generate. The crowdsourcing effort to fund the community is called an Initial Coin Offering (ICO).

One of the first — and clearly the most popular — cryptocurrencies established with a set limit for production is Bitcoin. An individual known only by the pseudonym Satoshi Nakamoto established Bitcoin and the technology to generate and manage the cryptocurrency in 2008. Nakamoto limited the number of Bitcoins generated by the distributed network of computers in his exchange to 21 million. This limitation in supply ensures demand for the tokens, which subsequently increase in value.

The Value of Bitcoin

At the end of August 2017, Bitcoin had an assigned trading value of nearly $5,000 for a single Bitcoin. This far exceeded the value of gold, which was about $1,300 at the time. However, within two weeks after the digital currency's high watermark, Bitcoin value dropped to about $3,000. Anyone who invested real currency in Bitcoin in mid-August and didn't pull out of the market before the price drop lost nearly 40 percent of the investment.

Because of its status as the most popular digital currency in the world, the Bitcoin community has become a standard in its own right, much like the heralded stock exchanges of Wall Street, London and Japan. As a result, when other digital currency markets falter, the value of Bitcoin also drops. In the case of the dramatic drop in value of Bitcoin at the end of August 2017, this occurred because other cryptocurrencies lost the support of the Chinese government after proliferating at an alarming rate in China throughout 2017.

The Chinese government feared the growth of huge and convoluted pyramid schemes revolving around cryptocurrency exchanges that had their own Bitcoin-like digital tokens. As a result, the government ordered exchanges like BTCC, OKcoin and Huobi to shut down by the end of September 2017. This edict sent shivers through global cryptocurrency exchanges around the world, and fear led to Bitcoin's rapid devaluation.

Now that Bitcoin has been shown to have a level of volatility that the gold standard and conventional currencies do not experience, it's unlikely that Bitcoin will become a global currency standard anytime soon.

Bitcoin Safety

Since 2010, almost a dozen hacks of cryptocurrency exchanges have occurred. Losses range in the hundreds of millions (dollars). Relatively speaking, however, conventional banking and financial institutions have lost billions of dollars to cybercriminals during this same timeframe. Programmers and cryptocurrency communities are working hard to identify and mend the vulnerabilities in their blockchain networks. If bitcoin becomes an acceptable currency for real-world vendors, government central banks may actually find their role upstaged by sophisticated computer algorithms.

On a personal level, anyone who invests in Bitcoin should have the proper internet security in place before accessing financial information and making transactions.